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Some money managers plan now for recession later

Alternative investment managers expect the best but are planning for the worst — a recession in as little as three years, just when they need to exit their portfolio holdings.

Several are preparing their portfolios to withstand any downturn. Some managers of real estate, private equity and other alternative investments are setting aside capital in case they need to hold the assets in their portfolios longer than planned, industry insiders say. Others are moving from what they view as trouble spots, such as retail real estate, or shifting to higher quality, senior secured debt investments and out of equity investments.

Managers are stockpiling capital, said Daniel Martin, a partner focused on real estate in the New York office of law firm McDermott, Will & Emery. “It's not dry powder but "wet powder,'” he said. “It's ... (capital) preserved in case they will not be able to refinance at the levels and rates they had intended” when investments were originally made.

Managers needing cash injections find them harder to get in a recession, he said.

One indication of increased manager caution is the percentage of equity vs. debt in private equity deals. The amount of equity in leveraged buyouts has been rising steadily — up 10 percentage points since 2013, according to data from S&P Capital IQ, to about 40% for large corporate buyouts and more than 45% for middle-market transactions.

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The added equity would help these companies weather declines of close to half of their enterprise values and still have enough capital available to cover expenses on their balance sheets, said Bill Sacher, a partner and head of credit in the New York office of alternative investment fund-of-funds manager
Adams Street Partners LLC.

“It's time to be cautious. The recovery is getting long in the tooth,” he said.

The availability of dry powder and the high valuations also are driving equity levels in deals, he noted. At the same time, leverage is high, not peaking yet “but getting close,” Mr. Sacher said.

“It would not surprise any of us to see a cycle downturn in the next three to five years,” he said. “That's exactly when you want to have dry powder” — committed but not yet invested capital — to take advantage of opportunities, he said.

While several managers are preparing their portfolios to withstand a recession, few expect a downturn in the next two years.

“In the next year or two, there is a decent chance of being pretty good,” said Matt Stroud, head of delegated portfolio management in the Americas in the New York offices of Willis Towers Watson PLC. But in three to five years, there is a possibility that policy changes by the Trump administration already priced into the markets could fail to materialize, and the markets would react negatively to that, he said.

At the same time, asset owners are searching for risk-mitigation strategies in light of a downturn they, too, think will be coming.

“There will be a recession at some point, and we want to put more balance in the portfolio,” said Tom Tull, chief investment officer of the $25.6 billion
Texas Employees Retirement System, Austin, speaking last month at the Pension Bridge annual conference in San Francisco. “We don't like leverage.”

Nobody knows what the catalyst of the next recession will be, said Adams Street's Mr. Sacher. “It usually is not what everybody expects.” Even so, this is a time to be cautious and selective, he added.

Ben Adams, CEO of Beachwood, Ohio-based real estate manager Ten Capital Management, said : “I don't know what will happen in the future. I think it is fair to guess there will likely be a correction and a shakeout. Certain retail is in trouble.”

Still, it is important to guard against painting entire sectors with the same broad brush.

Plus, in 2017 and 2018 there will be a great deal of real estate loans needing to be refinanced. “There are a number of big properties ... that are facing refinancing,” he said.

Some $47.6 billion in CMBS is scheduled to come due from April through December of this year alone, down from about $77 billion at the beginning of 2017, according to Morningstar. However, the CMBS maturity wave is approaching its end; CMBS maturities drop to $16.4 billion in 2018.

Looming loan maturities are also a factor in private equity. S&P Capital IQ calculates that $459 billion of existing leveraged loans will mature in the next five years, which could be hard to refinance in a recession.

“The irony of a recession is that it gets hot before it gets cold,” said Joseph Derhake, CEO of Partner Engineering and Science Inc., a Torrance, Calif.-based provider of engineering, environmental and energy consulting and design services for real estate investors, financial institutions and money managers.

Mr. Derhake sees danger signs in the current state of construction in certain areas, including coastal areas such as San Francisco and New York. Demand for new construction in the cities is so hot that contractors are being stretched.

“In construction, a contractor may have a great A team and a decent B team, but the contractor's C team is not very good,” Mr. Derhake explained. “In gateway markets, contractors and subcontractors are stretched. ... They are running more crews and more C teams out in the field, and that creates risk.”

The time element is also a risk. Contractors are rushing to complete projects for fear that otherwise they will be delivering completed projects in a recession, Mr. Derhake said.